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The Economic Times has a depressing story on the state of public finances in India:

…Expecting the fiscal deficit to come in at 4.1% of GDP for the whole of 2014-15 was widely predicted to be unrealistic, but the speed at which the gap between actual numbers and the projected figure has closed has exceeded earlier years. Last year, for instance, the fiscal deficit was around a third of the budgeted amount in the first two months of the year.

Essentially, what the government did was roll over, to the next year, payments which would have ideally come in towards the end of the previous financial year. The petroleum ministry, for instance, saw its expenditure for the first two months of this year coming in at 39% of its annual budget. In the same months of last year, the petroleum ministry had spent virtually nothing. Effectively what the government had done was delay payments of the fuel subsidy to oil companies till 2014-15. This way, it didn’t have to account for the expenditure in the previous year, resulting in a lower deficit. This way, it didn’t have to account for the expenditure in the previous year, resulting in a lower deficit. “The government left a number of expenditures uncovered,” points out Rajiv Kumar, senior fellow at the Centre for Policy Research.

Kumar points to the interesting fact that the fiscal deficit for the month of March last year was actually negative — in other words, the government received more funds into its coffers than was paid out of them for that month. “There was sharp fiscal compression in that month — more so than in earlier years,” he says, alluding to the fact that the government did not spend as much as it usually did.

March is an unusual month for government spending as the cement sector is well aware. Every March, cement consumption across the country spikes sharply. In recent years, that spike has been anywhere between 10% and 13%, but it’s followed in the subsequent month by a sharp fall. The spike is often because government departments would like to use up their budgets before the end of the financial year and binge on construction activity which was originally budgeted but failed to take off.

In contrast, in the early months of the new financial year, construction activity is slow as government budgets take time to be approved. Indeed government expenditure in March is regularly in excess of 15% of the budgeted amount for the year. In other months, the spending averages around 7-8%. In 2013 and 2014, though, the effect was more muted.

This, along with rolling over subsidy payments to the next year, helped the government push the fiscal deficit into negative territory. On the revenue side, dividend payments were sharply higher than originally budgeted for 2013-14 — by as much as 44%. “Notice also that the budgeted dividend payments by public sector undertakings [PSUs] for 2014-15 are much lower than earned in 2013-14,” says Sabnavis. Effectively the government asked PSUs to pay up higher amounts in dividends the previous financial year, with the sweetener that they wouldn’t be forced to do so again next year.

Then there is the tactic to give rosy estimates for the coming year, in order to give the markets and economists something to cheer about. Total subsidies for 2014-15 were pegged in the interim budget at just about 0.3% higher than the revised estimates for 2013-14. The government’s previous track record in managing subsidies gave little reason to believe this.

Last year, for instance, revised estimates were higher than their original budgeted amounts by 11%. Despite that experience, budget estimates were pegged at a lower level than a year before. At the same time, expectations of tax revenues are pegged at overly optimistic levels as well. All this means little fiscal room for Arun Jaitley when he presents his first budget next week.

India has enormous potential, but this story is yet another example of why India continues to fail to live up to her potential. I hope Premier Minister Narendra Modi’s new government will deliver on the promised reforms. Unfortunately given the historical experience it is hard to be optimistic.

Only a couple of days ago I was complaining that the Turkish (and the Polish) central bank(s) have been intervening in the currency markets. My complains of the Turkish central bank’s fear-of-floating and what seemed to be politically motivated monetary operations were then followed by the Brazilian central bank that hiked interest rates – officially to curb inflationary pressures, but what to me very much looked like an effort to prop up the Brazilian real.

It indeed seems like there is a pattern emerging in particularly in Emerging Markets. The latest central bank to jump on the FX intervention bandwagon is the Reserve Bank of India (RBI). This is from Reuters:

“The Reserve Bank of India (RBI) announced measures late on Monday to curb the rupee’s decline by tightening liquidity and making it costlier for banks to access funds from the central bank.

The RBI raised the Marginal Standing Facility (MSF) rate and Bank Rate each by 200 basis points to 10.25 percent, capped the amount up to which banks can borrow or lend under its daily liquidity window and announced a sale of government securities through an open market operation.

The RBI said total funds available under its repo window will be capped at 1 percent of banks’ deposits – roughly 750 billion rupees – from Wednesday. It announced a 120 billion rupee sale of government bonds for Thursday.

The central bank does not set a target for the rupee, which hit a record low of 61.21 to the dollar last week, but it does take measures to manage volatility”

It is very hard to be impressed by the RBI’s de facto currency targeting as there is hardly any economic arguments for the RBI’s actions, but we can safely conclude whatever motivated the RBI have just implemented significant monetary tightening.

Too easy AND too tight – it’s called stop-go monetary policy

I have earlier argued that there might be arguments for tightening monetary policy in India. Hence, since 2009 nominal GDP has risen much sharper than the earlier NGDP-trend of around 12% NGDP growth. The graph below illustrates this.

Furthermore, there is there is nothing “optimal” about a 12% NGDP growth path. In fact I believe that the RBI if anything rather should target an NGDP growth path around 7-8% (as I have argued earlier).

The problem with the RBI’s recent actions is not necessarily the decision to tighten monetary policy per se, but rather the in fashion it is done.

The RBI’s decision has clearly not been based on a transparent and rule based monetary framework.

Hence, after years of high NGDP growth and high inflation the RBI suddenly slams the brakes. And mind you not to hit an NGDP level target or an inflation target for that matter, but to “stabilize” the currency.

The result of this currency “stabilization” might be that the RBI will be able to curb the sell-off in the rupee (I doubt it), but we can be pretty sure that the cost of this “operation” will likely be a fairly sharp slowdown in Indian real (and nominal) GDP growth. You have to choose – either you have a “stable” currency or stable macroeconomic conditions. I fear that the RBI has just sacrificed macroeconomic stability in a ill-fated attempt to stabilize the currency – at least if the RBI insist to continue the policy of FX intervention.

In a sense the RBI has been pursuing both too easy monetary policies – too high NGDP growth and inflation – and at the same time too tight monetary policy in the sense of an abrupt monetary contraction to prop up the rupee. This is the core of the problem – the RBI’s counterproductive stop-go policies.

The way forward – a completely freely floating rupee and 8% NGDP target

In my view the RBI urgently needs give up its policy of fiddling with the currency and instead let the rupee float completely freely and instead announce an target on the nominal GDP level.

In my view the historical trend of 12% NGDP growth is too high and a lower NGDP growth target of 8% seems to be more appropriate. The RBI should hence announce that it gradually will slow NGDP growth to 8% over a five period. It is important that this should be a level target. Hence, if growth is faster than 11% in 2014 then it is important that NGDP growth will have to be even slower in the next four years. That is exactly the idea with a level target – you should not allow bygones-to-be-bygones. After 2018 the RBI will keep NGDP on 8% growth path.

Such a policy will ensure a lot more nominal stability than historically has been the case and therefore also very likely significantly increase macroeconomic stability.

Furthermore, a side effect will that the rupee likely will be more stable and predictable than under the present stop-go regime as FX volatility to a very large extent tend to be a result of monetary disorder.

A serious need for kick-starting economic reforms

There is no doubt that India seriously needs nominal stability, but there also is also a massive need for structural reforms in India. I think this story (quoted from Bloomberg) tells you everything you need to know about the extent of harmful and unnecessary government intervention in the Indian economy:

“For more than 100 years across the 19th and 20th centuries, its gnomic messages, worked into Morse code and out into language again, then delivered by postmen, connected human beings in faraway places. It announced births, marriages and deaths; called soldiers home from war or announced their demises to their families (or changed the course of the war itself); confirmed job offers or remittances to anxious and impatient souls. The voice of history whenever it was in haste, it was stoic by nature — concealing waves of emotion under its impassive, attenuated syntax — and easily available to rich and poor, in city and village.

In India, it was installed by the British as a way of administratively and militarily linking up the vast reaches of the subcontinent. But it became one of the engines of the freedom movement, a way for the Indian migrant to keep up a tenuous link to the world he had left far behind. The Indian word for it was “taar,” or wire, invoking an image more concrete than the English “telegraph.” (The “wire,” in English, was claimed by news media services.) Long after the rest of the world had moved on to more advanced technologies, the humble telegraph continued to enjoy great currency in India, before the onset of the digital revolution began to chip away at its hegemony. But the end has been in sight for some years now.

With the explosion of the mobile-phone revolution in the last decade (described recently in “The Great Indian Phone Book“), the telegraph service began for the first time to appear anachronistic. Text messages sent from mobile phones began to make the taar service seem quaint, even to rural users. This weekend, Bharat Sanchar Nigam Ltd, the state-run company that runs the system, is finally set to wind down its telegraph service for good, just as Western Union decided in 2006 that it was over for its telegrams in the U.S. Almost 16 decades after a member of the Indian public sent a telegram for the first time in 1855, the telegram will finally give up the ghost in one of its last surviving redoubts.

The Indian telegraph service still processes about 5,000 telegrams each day (most of them government notifications).

It is truly bizarre that a developing country like India until this day has continued to have a government run telegraph company, but I think it tells you a lot about how extreme the level of government intervention in the Indian economy still is.

In the 1990s growth was kick-started by a number of supply side reforms. However, over the past decade speed of reforms have been much more slower and in some area reforms have even been scaled back.

In this regard it should be noted that inflation has been stubbornly high – around 7-8% (GDP deflator) – since 2009. But at the same nominal GDP growth has slowed. This to me is an indication that while monetary policy has indeed become tighter India has also at the same time seen a deterioration of supply side conditions. The result has been a fairly sharp slowdown in real GDP growth in the same period.

I think it is quite unclear what is potential real GDP growth in India, but I think it likely is closer to 5-6% than to 8-10%. This would seems to be a quite low trend-growth given the low level of GDP/capita in India and India’s trend-growth seems to be somewhat lower than that of China.

Concluding, while a monetary regime change certainly is needed in India serious structural reforms are certainly also needed. The best place to start would be to get rid of India’s insanely high trade tariffs and generally opening up the economy significantly.

Update: s shorter edition of this blog post has also been published at financeasia.com. See here.

Take a look at this “Phillips” curve for India (its not really a real Phillips curve – as it is the relationship between annual real GDP growth and inflation):

Do you notice something?

Yes you are right – the slope of the Phillips curve is wrong. Normally one would expect that there was a positive relationship between real GDP growth and inflation, but for India the opposite seems to be the case. Higher inflation is associated with lower GDP growth.

The reason for this obviously is that supply shocks is the dominant factor behind variations in Indian inflation. That should not be a surprise as nearly 50% of the consumption basket is food.

Rain as a supply shock

A closer scrutiny of the Indian inflation data will actually show that the swings in Indian inflation primarily is a rainy phenomenon. Hence, the Indian monsoon and the amount of rainfall greatly influences the food prices and as a result short-term swings in inflation is primarily due to supply shocks in the form of more or less rainfall.

Obviously if the Reserve Bank of India (RBI) was following a strict ECB style inflation target then monetary policy would be strongly pro-cyclical in India as negative supply shocks would push up inflation and down real GDP growth and that would trigger a tightening of monetary policy. This would obviously be an insanely bad way of conducting monetary policy and the RBI luckily realises this.

The RBI therefore focuses on wholesale prices (WPI) rather than CPI in the conduct of monetary policy and that to some extent reduces the problem. The RBI further try to correct the inflation data for supply shocks to look at “core” measures of inflation where food and energy prices are excluded from the inflation data.

However, the problem with use “core” inflation that it is in no way given that changes in food prices is driven by supply factors – even though it often is. Hence, demand side inflation might very well push up domestic food prices as well. Hence, it is therefore very hard to adjust inflation data for supply shocks. That said it is pretty hard to say that the RBI has followed any consistent monetary policy target in recent years and inflation has clearly been drifting upwards – and food prices can likely not explain the uptrend in inflation.

On the other hand NGDP targeting provides the perfect adjustment for supply shocks and it would therefore be much better for the RBI to implement an NGDP target rather than a variation of inflation targeting. Unfortunately at the present the RBI don’t really officially target anything and monetary policy can hardly be said to be rule based. As I stressed in my earlier post on Indian monetary policy the RBI needs to move away from the present ad hoc’ism and introduce a rule based monetary policy.

PS Monetary policy is certainly not India’s only economic problem – and not even the most important economic problem. I my view India’s primary economic problem is excessive interventionism in the economy, which greatly reduces the growth potential of the economy.

PPPS The link between rain, inflation and monetary policy in India is being complicated further by the fiscal response in the form of food and agricultural subsidies in India, but that is a very long story to tell…

There is no doubt that the popularity of NGDP level targeting is increasing and with that partly also the popularity of Market Monetarism. However, as the popularity is growing so is the misunderstandings about both.

First, I would stress that while Market Monetarists advocate NGDP level targeting the two things should not be seen as the same thing. NGDP level targeting is a monetary policy advocated by Market Monetarists, but also by others – such as certain New Keynesian economists such as Christina Romer and Michael Woodford. Market Monetarism on the other is an economic school – or said in another way – it is a way to think about monetary policy and monetary theory.

Today I came across an interesting article by Niranjan Rajadhyaksha with the intriguing headline “India does not need market monetarism” that illustrates some of the misunderstandings about Market Monetarism and NGDP level targeting.

Here is from the article:

The Bank of Japan said on Tuesday that it would try to push up inflation as part of a new strategy to stimulate the economy. Such an attempt would have been met with gasps of disbelief a few years ago, when low inflation was the central quest of monetary policy. A higher inflation target is now becoming an important part of the ongoing policy debate, at least in the developed countries that are still struggling to recover from the economic effects of the financial crisis.

What has just happened in Japan is another victory for a group of economists called market monetarists, who have argued over several years that policymakers should target the nominal gross domestic product (NGDP), which is a combination of real output and inflation. Targeting nominal GDP can be contrasted with what the two main schools of macroeconomics suggest: the traditional monetarists look at money supply and the new Keynesians look at interest rate.

Well, yes it is a victory in the sense that the Bank of Japan now finally is clear on what the central bank is targeting (2% inflation). However, Market Monetarists would certainly have preferred an NGDP level target to an inflation target.

Niranjan continues:

The market monetarists once tried to be heard from the sidelines. They have since gained popularity and are now an important voice in the corridors of power. The US Fed has not yet embraced nominal GDP targeting, but there are signs that market monetarism is getting heard in that institution. Chicago Federal Reserve president Charles Evans is one important convert.

The new Bank of England governor Mark Carney is known to be sympathetic to the market monetarist cause. Japanese Prime Minister Shinzo Abe has also been talking about pushing up Japanese nominal GDP, and his influence in evident in the new Bank of Japan policy statement. All implicitly believe that a higher inflation target will goad rational consumers to spend before prices go up, thus boosting economic activity

So far so good, but again an higher inflation target in Japan is not an NGDP level target, but certainly better than the non-target the BoJ has effectively been practicing for the past 15 years.

But then it goes wrong for Niranjan:

The situation in India is very different. It is unwise to use higher inflation as an important part of any strategy for economic recovery, though there has been loose talk of allowing the Reserve Bank of India to let its unofficial inflation target rise. India already suffers from structurally high inflation. Inflation expectations seem to have drifted up in recent years. These will damage the economy in the long run.

Yet the Indian government has been following a perverse variant of nominal GDP targeting. High inflation has led to robust nominal GDP growth despite the slowdown in real output, which in turn has ensured that the burden of public debt in India has not expanded despite large fiscal deficits. Look at the numbers. Nominal growth in fiscal 2011 was 17.5%, the highest in 20 years. Nominal GDP growth has been growing faster in the four years after the global financial crisis than in the four years that preceded it. In other words, the Indian government has been inflating away its old debts, most of which are held by Indian households through the banking system.

Market monetarism and nominal GDP targeting may make sense in economies that have persistent negative output gaps and interest rates at the lower bound. India is in a different situation. It needs lower inflation to get its economy back on track.

Niranjan seems to equate Market Monetarism and NGDP level targeting with a desire for higher inflation. The fact is, however, that Market Monetarists don’t advocate higher inflation. We advocate a higher level of NGDP for countries such as the US or the euro zone where the level of NGDP is well below the pre-crisis trend level. We don’t concern ourselves with the “split” between real GDP and the price level – the only thing we concern ourselves with is the NGDP level.

Furthermore and much more importantly we are advocating a rule based monetary policy – so we are not advocating the central bank should jump from one stance of policy to another in a discretionary fashion.

In addition Market Monetarists are not “hawks” or “doves”. We are doves when the actual level of NGDP is below the targeted level of NGDP and hawks when the opposite is the case. So yes, for the US or the euro zone we might sound as “doves” in the sense that we (the Market Monetarist bloggers) have been advocating easier monetary policy to bring back NGDP “on track”. What we are arguing is not “stimulus” in a discretionary fashion, but rather a return to a rule based monetary policy.

But what about India?

From 2000 and until the outbreak of the Great Recession in 2008 Indian NGDP grew by around 12% a year. There is is obviously nothing “optimal” about that number, but lets as a starting point see that as our benchmark.

The graph below shows the actual level of Indian NGDP and a 12% growth path for NGDP starting in 2000.

The graph is pretty clear – actually NGDP has been running well above the 12% path in recent years. So if the Reserve Bank of India (RBI) had targeted a 12% NGDP level path then it would certainly had kept a tighter monetary stance in recent years than what actually have been the case.

Hence, the Market Monetarist advise to the RBI would be to tighten monetary policy – rather than the opposite.This illustrates that Market Monetarism is not about being “hawkish” or “dovish”. It is about advocating a rule based monetary policy and at the moment a 12% NGDP level target for India would mean that the RBI should tighten – rather than ease . monetary policy.

Therefore, Niranjan is certainly right when he is arguing that India does not need monetary easing, but that is exactly the conclusion you would reach as a Market Monetarist!

In fact I think that most Market Monetarists would think that a 12% NGDP level target for India is too high and I would personally think a long-term NGDP level target path should be around 7-8% rather than 12%.

Concluding, if the RBI had an NGDP targeting rule it would have kept monetary policy significantly tighter in recent years. The actual conduct of monetary policy in India has nothing to do with Market Monetarism. The only difference between the ECB and the RBI is that the ECB failed on the “tight side” while RBI failed on the “easy side”.

So Niranjan, you are right to worry about the RBI’s overly easy monetary policy, but don’t blame Market Monetarism. You should rather endorse it. We are with you – the RBI has failed exactly because it has not conducted monetary policy within a rule based framework and the RBI should tighten monetary policy sooner than later. And of course introduce an NGDP targeting rule asap.

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PS a major advantage of NGDP level targeting compared to inflation targeting is that NGDP level targeting would “ignore” supply shocks. This is very important for an Emerging Market economy like India where headline inflation often is driven by supply shocks in the form of changes in food and energy prices.

Hence, it is well-known that most of the short-term variation in Indian inflation is driven by food prices. A strict inflation targeting central bank would react to higher inflation by tightening monetary policy – this is of course the ECB style inflation targeting regime. Contrary to this an NGDP level targeting central bank would not react to supply shock and instead just keep NGDP on track.